Italy may trigger new global crisis

Economic, political and constitutional troubles converge on Rome

by Desmond Lachman in Washington

Wed 30 May 2018

In choosing this moment to heighten trade tensions with Europe, Donald Trump is ignoring major economic and political upheaval in Rome. Trouble in Italy, the euro area's third largest economy, has the potential to trigger a global economic disaster on the scale of the 2008 financial crisis.

Before enforcing restrictive trade measures that might blacken Europe's economic outlook, the Trump administration should remind itself of Italy's systemic importance to the world economy. Italy's economy is 10 times larger than that of Greece, whose debt crisis shook the euro area's foundations. The single currency is unlikely to survive in its present form if Italy were forced to exit that monetary arrangement.

The country has the world's third largest sovereign debt market, after the US and Japan, with total public debt of more than $2.5tn. A default, as would almost certainly happen were the Italian government's borrowing costs to increase on leaving the euro, would almost certainly spark a European banking crisis that would reach the US.

Trump might also want to consider Italy's precarious economic situation. Remarkably, Italy's per capita income is lower today than it was on the eve of the country's euro adoption in 1999. Equally remarkable is the fact that, over the past decade, Italy has experienced a triple-dip recession. It is yet to regain its pre-2008 output level.

Italy's sclerotic economic performance amplifies its financial market vulnerabilities. Its public debt to GDP ratio is 133% of GDP, which makes Italy the second most indebted country in the euro area after Greece. A lack of economic growth has also contributed to the weakening of Italy's banking system. This is underlined by its level of non-performing loans, at around 15% of the banking system's balance sheet.

To date, Italy's weaknesses have been masked by a highly favourable global liquidity environment as well as the European Central Bank's large-scale purchases of Italian government bonds as part of its quantitative easing programme. However, this era of easy liquidity is nearing its end. Over the past year, the benchmark US 10-year Treasury bond yield has doubled to 3%, while the ECB is scheduled to wind down its QE programme by the end of the year.

Rome must reform the economy to deliver growth that would allow it to reduce its vulnerabilities. As Ignazio Visco, governor of the Banca d'Italia, stated on Tuesday, Italy is at a 'very serious risk of losing the irreplaceable asset of trust'. However, meaningful positive reform seems unlikely to occur given the country's deepening political crisis.

Following their success in the March 2018 parliamentary elections, the populist Five Star Movement (M5S) and far-right League between them command a parliamentary majority. Both parties wish to roll back the preceding government's economic reforms, to the frustration of Italy's European partners. The parties also support budget-busting measures such as a basic income programme and a flat income tax.

Economic and political troubles are compounded by a constitutional crisis. On 26 May, President Sergio Mattarella controversially vetoed the forming of a M5S-League coalition government. This is likely to lead to new parliamentary elections, probably in October. These could, in practice, become a referendum on Italy's euro area membership and will usher in a prolonged period of economic uncertainty.

The last thing Italy needs is a heightening of US-Europe trade tensions that could deal a heavy blow to the European economy. Yet this is precisely the direction in which the Trump administration appears to be heading. Not content with imposing steep aluminium and steel import tariffs on Europe, Trump is floating the idea of imposing import tariffs on European automobile imports.

Given the close economic and financial market ties between Europe and the US, one would think supporting a healthy European economy is in Washington's vital economic interest. The Trump administration should pivot quickly from a confrontational to a co-operative policy stance. However, judging by its unyielding commitment to a narrow 'America first' worldview, markets should not expect this to happen.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund's Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.